Second Quarter 2013 Financial Market Commentary

To taper, or not to taper, that is the question that investors are currently grappling with:

In every year since 2010, the global stock markets have started the year in an optimistic mood only to run into trouble in the late spring/early summer. This year has been no different. This time there is little doubt about the cause. The Federal Reserve (Fed) has suggested that unless the American economy deteriorates, it may start to slow the pace (taper) of its asset purchases ($85 billion/month) later this year and may stop the purchases in 2014.

Investors reacted to the potential loss of this support by selling both stocks and bonds. What is striking is the breadth of asset classes that have fallen in price in recent weeks. Stocks around the globe declined with some markets (including China’s) now 20% below their recent peaks. Government bonds suffered with yields rising sharply in all developed and emerging sovereign bond markets. As for commodities, the gold and silver markets were hammered along with a sell-off in economically sensitive raw materials such as copper.

For the quarter, the performance of U.S. stocks led the way, particularly the Small Cap and Large Cap segments (see Table #1). Except for Mid Cap stocks, every other broad asset class generated flat to negative returns for the quarter. Emerging markets stocks were the worst performer as investors were caught off guard, not just by worries about the Fed but also by concerns about China's economy transitioning from being export-driven to more consumption-oriented. In addition, political unrest in Brazil, Turkey, and Egypt did not help matters. Commodities were the next worst asset class led lower by gold prices falling 23% in the second quarter, the biggest quarterly decline since trading of U.S. gold futures began in 1974.

As for bonds, U.S. Treasury yields rose/prices declined across the curve, particularly in the 7-10 year maturity range. All sectors within the fixed income market generated negative total returns for the quarter. U.S. bond mutual funds saw record monthly redemptions of $61.7 billion through June 24, according to Trim Tabs Investment Research, amid concern the Fed may scale back its unprecedented stimulus.

TABLE #1: 2013 2nd Quarter and 1 Year Ending June 30th - Asset Class Index Returns

*Source: Bloomberg and Bank of America/Merrill Lynch Indices

After posting their best start to a year in the past two decades during the first quarter, stocks ended the second quarter in a simultaneous sell-off with bonds. During the month of May, global bond markets posted their biggest monthly losses in nine years as the U.S. dollar rallied and stocks reached record highs amid speculation a strengthening U.S. economy will allow the Federal Reserve to reduce its monetary stimulus. Fed Chairman Ben S. Bernanke said during a response to questions following Congressional testimony on May 22nd that the Central Bank could consider reducing the amount of Treasuries and mortgage debt it buys within “the next few meetings” if officials see signs of sustained improvement in the labor market. Following these comments by the Fed Chairman, stocks and bonds sold-off.

Then, in a press conference following the FOMC’s June 19th meeting, the Fed Chairman mapped out a timetable for ending one of the most aggressive easing strategies in Fed history. If economic data are consistent with the Fed’s forecasts, “the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,” Bernanke said. “We will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.” Stocks and bonds once again sold-off in unison. Behind the recent change of heart among investors is a belief that the economy may be picking up enough steam to prompt the Fed to scale back or taper its $85 billion per month in bond purchases.

The Fed’s current economic forecast is as follows:

• U.S. unemployment rate will fall to 6.5% to 6.8% by the end of 2014
• The economy will grow 2.3% to 2.6% this year and 3% to 3.5% in 2014
• The PCE index (Fed’s preferred measure of inflation) will rise 0.8 - 1.2% this year and 1.4 - 2% in 2014

The Fed’s dilemma is that the unemployment rate is far higher than it wants, and the pace of inflation is far too low. Although the economic recovery has shown more signs of life with the revival of the housing market making news in the past few weeks, the Fed still has cause for concern. The unemployment rate at 7.5% is well above the 5.5% it considers optimal and lowering unemployment is important for long-run growth. As the effects of the fiscal tightening that came from the Federal budget sequester begin to fade, and as companies recognize that neither the cuts nor this year's increase in taxes bucked the economy as some had feared, hiring could shift into a higher gear. In the meantime, the Fed's preferred measure of consumer prices shows little in the way of inflation with a reading of 1.1% on a year-over-year basis.

Our takeaway is that recent worries among bond investors over how soon the Fed will curtail its $85 billion a month in Treasury and mortgage purchases are probably overblown. Although the Fed may reduce the pace of purchases if the job market shows a few more months of marked improvement, it will do so only gradually. Fed officials believe reducing bond purchases wouldn't constitute a reduction of monetary stimulus, but merely would cut the pace of additional stimulus. We agree. A tapering of asset purchases is not a monetary tightening, but rather a Fed easing at a slower rate. Although the U.S. economy is indeed on firmer ground, we believe that it is nowhere near strong enough to warrant the Fed ending its bond buying program anytime soon, let alone beginning to raise interest rates.

Stocks have been rallying now for months not because of expectations for endless Fed bond buying, but rather in anticipation of mildly improving economic conditions, healthy corporate balance sheets and earnings, Central Bank monetary policies that will remain very accommodative, and reduced tail risks (European debt crisis, China’s economic slowdown, Japanese bond volatility, and higher U.S. Treasury bond yields). The stock market acts as a forward discount mechanism meaning it has been assuming a tapering in Fed monetary accommodation once the economic recovery proves to be sustainable. It’s always tough to gauge the Fed’s expectations, but increasingly many investment professionals think the Sept 18th Fed meeting is the one at which a formal “tapering” announcement could come. This would be followed by a reduction in monthly bond purchases from the current $85 billion to $50-65 billion beginning in November. While September 18th could be the formal announcement, the Fed’s rhetoric will continue shaping market expectations in the months ahead to ensure that investors are fully prepared when the monthly purchase pace drops under $85 billion.

Many people continue to look for reasons why stocks shouldn’t be at their present levels instead of appreciating the reasons why they’re here. The list of perceived “tail risks” in the world remains very lengthy i.e. Europe, China, Japan, and higher bond yields. The most popular perceived risk lately is higher U.S. Treasury yields. Some are fearful that stocks can’t possibly stay at present levels or move higher in price with 10 year U.S. Treasury Note yields above 2.5%. What if the “tapering” of bond purchases by the Fed causes a 1994-like bond market sell-off? We believe that this fear is overdone because it’s difficult for us to imagine a significantly higher and sustained level of bond yields/interest rates given the impact of aging demographics and structural headwinds to growth. Aging populations save more, spend less, and need income. The enormous amount of deleveraging (paying down debt) continues, private credit demand remains weak, inflation remains low (Core Personal Consumption Expenditures Index is 1.1%), there is an abundance of global savings that needs to find a home, U.S. Treasuries and the dollar are viewed as safe haven assets in times of volatility, uncertainty, and heightened geopolitical risks, and the unemployment rate remains stubbornly high with the official rate at 7.6% and the underemployment rate at 14.3%.

Stocks, rather than bonds, have been the more accurate asset class for months now in predicting a slowly recovering economy. With the S&P 500 Index currently trading at a Price/Earnings ratio of 15.75 (earnings yield of 6.35%) compared to the historical average of 16.5, stocks are still far from expensive. Bond yields are starting to play catch-up as they rise in anticipation of a stronger economy resulting in less monthly bond purchases by the Fed, but should prove to be more than tolerable for stock prices. In theory, 10 year U.S. Treasury Note yields should be close to the nominal GDP growth rate over time (currently 3.2% = 1.4% inflation + 1.8% real growth). Going forward, we believe that stocks would much rather prefer an environment of improving growth and reduced accommodation instead of the alternative.

No significant changes to our tactical positioning took place during the second quarter. We remain cautious and slightly underweight risk-based assets versus strategic targets. Now that the Fed has let the cat out of the bag and telegraphed its intentions to reduce/end its bond buying program if the economic data warrants, financial market trading will become very data dependent with volatility most likely on the rise. In such an environment, we continue to favor U.S. equities, particularly Large-Cap stocks. We are equal-weight to our strategic targets in U.S. Mid Cap and Small Cap stocks, Emerging Markets stocks, REITs, and Commodities. We remain underweight International developed market stocks, High Yield bonds, and U.S. Treasuries.

To help protect our bond allocations against rising interest rates, we have kept taxable portfolio duration (measure of interest rate risk) at 3.1 years which is 80% of the benchmark index duration. The rule of thumb for duration is that for every 1% increase in interest rates, the price of a bond will decline by the bond’s duration or in this case, 3.1%. However, the bond’s coupon income will help offset a portion of the price decline in the total rate of return calculation. Additionally, we have remained overweight in spread product – Investment Grade Corporate Bonds and Mortgage-Backed Securities. Since higher interest rates are usually the result of stronger economic activity and since a strong economy often helps corporate earnings, credit spreads should narrow/prices rise as yields on U.S. Treasuries rose in response to an improving economy. We have also invested in 3-4 institutional share class mutual funds that are opportunistic strategies designed to generate positive returns in any interest rate environment. All have durations less than 1.5 years. We use mutual funds because we can’t replicate these strategies using individual bonds and there is no ETF that provides diversified exposure to this segment of the bond market.

Lastly, for client portfolios where practical, we invest in high-quality individual bonds that mature at par value. Investing in high-quality individual bonds and holding them to maturity is a good strategy when rates rise. It protects principal and avoids losses in a way that bond funds cannot. As rates rise, the prices of the underlying bonds in a bond fund fall. If prices fall by more than the coupon payments of the bonds in the portfolio, total return becomes negative. However, individual bonds do not experience the same losses when held to maturity. Instead, high-quality individual bonds will deliver the scheduled cash flows from the coupons and return principal.

We are getting closer to the end of the Federal Reserve’s unprecedented easy money policies. As long as the Fed keeps injecting the economy with cheap-to-borrow money, there is room for both stocks and bonds to perform well. However, an eventual divergence will come about when it becomes clear the Fed is ready to pull back.

If investors are convinced the economy is strong enough to grow without Fed support, stocks would likely move higher in price while U.S. Treasuries would decline. If investors believe the Fed's withdrawal is premature, then stock prices would likely fall and demand for U.S. Treasuries would rise. This scenario happened a few times over the past four years when one Fed bond buying program ended without a new one beginning. This time around, the sell-off in the government bond market appears to validate a global economic recovery in a disinflationary (slowing of inflation) environment.

Since the stock market bottomed in early March of 2009, investors that were brave and rational could have made significant returns over the past four years. Currently, since U.S. Large Cap stocks are near all-time highs, government bond yields are just off historical lows, and spreads for mortgage-backed securities, municipal bonds, investment-grade corporate bonds, and high yield bonds are near all-time tight levels, investors will need a broader view of the financial markets and a balanced and tactical approach to active management in order to make money in the next four years.

Andrew Zimmerman – Chief Investment Strategist

Notes: The DT Investment Partners’ Commentary and Outlook discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only. The material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Investments in various asset classes entail different investment risks. For example, small cap stocks tend to be more volatile than large or mid-cap stocks. International and emerging markets stocks have exposure to currency fluctuations, foreign taxes, political instability and the possibility for illiquid markets. Fixed income investments involve interest rate and credit risks among others. Real estate investing includes risks such as declines in value of real estate, changing economic conditions, tax laws or property taxes. Commodities’ investing is highly volatile and subject to changing economic conditions and the vagaries of speculators among other risks. Further, diversification and strategic or tactical allocation do not assure profit or protect against loss in declining markets. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.

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